Chapter 20

BAD DEBTS
&
ALLOWANCE FOR DOUBTFUL DEBTS
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Explain and show how bad debts
are written-off

Explain why allowances for

doubtful debts are made

Objectives
Make entries to record an
allowance for doubtful debts in the
books

Make entries in the income

statement and statement of
financial position for bad debts and
allowances for doubtful debts
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Bad Debts

 Businesses take risk that some customers may

never pay for goods sold on credit

 This is a normal biz risk

 Bad debts are normal biz expense

 Charged to I/S as an expense

 Remove the bad debt from the asset acc –

closing debtor’s acc..
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Bad Debts

 When debt is found ‘bad’

 The asset as shown in debtor’s
acc is worthless
 Must be eliminated from the acc
 If it reduces the balance to 0 –
debtor’s acc is closed

 Double entry:
 Dr Bad Debts Account
 Cr Debtor’s Account
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Bad Debts

 Possible scenarios that may exist

concerning a bad debt:

 Debtor refuse to pay one of a no. of

invoices
 Debtor refuse to pay part of the
invoice
 Debtor may owe payment on a no. of
invoices & indicated only proportion
will be paid as biz has failed
 Debtor’s biz failed – nothing likely to
be received
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Whatever the reason, once a
debt has been declared ‘bad’ –
journal entry is the same!

Bad Debts At the end, the total bad debts

account is transferred to the I/S

Example 20.1
Allowance for Doubtful Debts 7

When drawing up
financial stmts, the
following objectives
must be achieved:
• To charge, the amount
representing debts that will
never be paid, as an expense
Why allowances are needed? in I/S for that year
• To show the accounts
receivable figure that is close
as possible to the true value
of accounts receivable to-date
in the B/S
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Debts declared ‘bad’ are usually debts that have

existed for some time – i.e. previous accounting
periods

But how about debts that have not been paid by the
Allowance for year end??

Doubtful These may not have been owing for so long – in

Debts this case, it’s more difficult to determine which of
them will be bad debts

All biz experience bad debts – it is likely that at

least some of these debts will ultimately prove to
be bad!
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 The possibility that some debts will
Prudence turn ‘bad’ needs to be provided for in
the current period – otherwise:
Concept
 Acc Receivable balance in B/S will be
overstated

 The profit in I/S will also be overstated

Allowance for Doubtful Debts 1
0

So how to decide on the amount

Impossible to determine with
of provision / allowance, against
absolute accuracy at year end
the possibility of some remaining
what the true amount is in
debts proving ‘bad’ in the future
respect of debtors who will never
(after removing bad debts written
pay their accounts
off) ??
Allowance for Doubtful Debts 11

 In order to arrive at a figure of

doubtful debts:

 Look at each debt & decide to

what extent it will be ‘bad’

 Estimate on the basis of

experience, what % of the total
amount due from the remaining
debtors will turn to be ‘bad’
Allowance for Doubtful Debts 1
2

The longer a debt is owing, the more likely it will

turn ‘bad’

Older debtors – higher % bad debt compared

Some biz use an ‘ to newer debtors

ageing schedule’: % reflect actual pattern of bad debts

experienced in the past
Allowance for Doubtful Debts 1
3

They apply a
% will be one
general % to
the biz
the overall
However most established
balance of acc
biz don’t do over the years
receivable
this as being the
(after
most
deducting bad
appropriate
debts)
Accounting Entries – Allowances for 1
4
doubtful debts

Year in which the allowance is 1st made:

Cr Allowance for Doubtful Debts
Dr P&L
Acc

Example 20.3
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Accounting  2 different accounts are used to make

2 different types of adjustments to acc
Entries – receivable:
Allowances
for doubtful  To make it clear how much is:

debts  being written-off as bad debts

 being treated as an allowance for
doubtful debts
Accounting Entries – Allowances for 16
doubtful debts

Bad debts account:

This exp acc is used when a debt is believed to be irrecoverable and is written-off

Allowance for doubtful debts acc:

Used only for estimates of the amount of debt remaining at the
year end after bad debts are written off – that are likely to end Also known as Allowance for Bad Debts Account
up as bad debts!
Accounting Entries – Allowances for 17
doubtful debts

Charging both in the I/S – the full picture is presented in respect of bad debts & doubtful debts

Both these amounts are deductions from gross profit

In B/S, a net figure is attained – represents more accurate figure of the value of acc receivable than the
total of ALL A.R. figure in the Sales ledger

It may not be absolutely accurate – only time will tell which debt will turn bad!

It’s better than not making an estimate at all!

Similarities
Provision for Depreciation
Dr P&L
Cr Against Fixed Asset
Estimate how much of the
overall economic usefulness of
a fixed asset has been used up
in each accounting period
Can never be completely
accurate since only in several
years (when asset it put out of
use) can it be determined if
prov. have been appropriate.
18
Allowance for D. Debts
Dr P&L
Cr Against Current Asset
Estimate how much of the
total debts will turn to be bad
in times to come
Can never be completely
accurate since only time will
tell which debt will turn out to
be bad.
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Increasing the Allowance 9

 Using the same example earlier – at the end of the following year (31 Dec 2009)
– the allowance for doubtful debts needs to be increased

 Allowance was kept at 2% & acc receivable figure was raised to $12,000

 An allowance of $200 had been b/d from previous year – but we now want a total
allowance of $240 (2% x $12,000)

 Need a provision of an extra $40

 Dr P&L (The increase in the allowance)
 Cr Allowance for Doubtful Debts Acc
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Reducing the Allowance 0

 To reduce the allowance, do the opposite to what you did to

increase it

 Allowance for doubtful debts has a credit balance

 To reduce it, a debit entry is needed

 The credit is the P&L acc

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Reducing the Allowance 1

At 31 Dec 2010, the

figure for A.R. had fallen
to $10,500

An allowance of 2%
remained ($210) = 2% x
$10,500
Dr Allowance for
Doubtful Debts
Previous allowance was
$240 – now needs to be
reduced to $30 ($240 -
$210)
Cr P&L Acc (add it as a
gain to Gross profit)

Example 20.5
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Bad debts Recovered 2

 If a debt written-off in previous years is recovered:

 Reinstate the debt by making the following entries:

 Dr Debtor’s Acc
 Cr Bad Debts Recovered Acc

 When payment is received from the debtor in settlement of all or part

of the debt:
 Dr Cash/Bank
 Cr Debtor’s Acc 
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Bad Debts Recovered 3

 At the end of the financial year, the credit balance in the Bad debt
Recovered acc is transferred to:

 Dr Bad debts recovered acc (out)

 Cr Bad debt acc
OR
 Cr P&L acc – effect is the same – since bad debts acc will be
transferred to the P&L acc at the year end!
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4
Review questions 20.4A,20.6A &
Tutorials

20.11A
 Answers will be discussed in the next
class
 Please attempt other questions as
well.
It is for your own benefit..